Ch. 4 - The Time Value of Money

Topics Covered Future Values Present Values Multiple Cash Flows Perpetuities and Annuities Effective Annual Interest Rate Inflation & Time Value 2

Compounding and Discounting Single Sums The Time Value of Money Compounding and Discounting Single Sums

Future Values Future Value - Amount to which an investment will grow after earning interest. Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original investment. 3

Future Values Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Interest Earned Per Year = 100 x .06 = $ 6 5

Future Values Example - Simple Interest Interest earned at a rate of 6% for three years on a principal balance of $100. Today Future Years 1 2 3 Interest Earned 6 6 6 Value 100 106 112 118 Value at the end of Year 3 = $118 8

Future Values Example - Compound Interest Interest earned at a rate of 6% for three years on the previous year’s balance. Interest Earned Per Year =Prior Year Balance x .06 14

Future Values Example - Compound Interest Interest earned at a rate of 6% for three years on the previous year’s balance. Today Future Years 1 2 3 Interest Earned 6.00 6.36 6.74 Value 100 106.00 112.36 119.10 Future Value of $100 compounded at 6% for three years = $119.10 15

Future Value of Single Cash Flow 21

Future Values Example - FV What is the future value of $100 if interest is compounded annually at a rate of 6% for three years? 23

Future Values with Compounding Interest Rates 24

Example: Mutual Fund Fees and Retirement Savings Prof. Finance moves to a new university and has $100,000 in retirement savings to invest (rollover) into a new retirement account. Prof. Finance wants to invest this money for 25 years into an indexed stock fund, which is expected to return 9% annually. Prof. has two choices: Vanguard Total Equity Fund with a 0.4% annual expense fee and Onguard Total Fencing Fund with an 1.2% annual expense fee. What is the difference in Prof. Finance’s expected future retirement savings between the two funds?

Present Values Present Value Value today of a future cash flow. Discount Factor Present value of a $1 future payment. Discount Rate Interest rate used to compute present values of future cash flows. 31

Present Values 32

Example: Paying for Baby’s MBA Just had a baby. You think the baby will take after you and earn academic scholarships to attend college to earn a Bachelor’s degree. However, you want send your baby to a top-notch 2-year MBA program when baby is 25. You have estimated the future cost of the MBA at $85,000 for year 1 and $89,000 for year 2.

Example: Paying for Baby’s MBA Today, you want to finance both years of baby’s MBA program with one payment (deposit) into an account paying 8% interest compounded annually. How large must this deposit be?

Time Value of Money (applications) Value of Free Credit Implied Interest Rates Internal Rate of Return Time necessary to accumulate funds 39

Example : Finding Rate of Return or Interest Rate A broker offers you an investment (a zero coupon bond) that pays you $5,000 five years from now for the cost of $3,700 today. What is your annual rate of return?

Important Time Value Relationships Increasing interest rate and time increases future value. POSITIVE RELATIONSHIP. Increasing interest rate and time decreases present value. INVERSE RELATIONSHIP.

Compounding and Discounting The Time Value of Money Compounding and Discounting Cash Flow Streams 1 2 3 4

Perpetuities Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity.

Perpetuities PV of Perpetuity Formula C = cash payment r = interest rate 45

Perpetuities & Annuities Example - Perpetuity You want to create an endowment to fund a football scholarship, which pays $15,000 per year, forever, how much money must be set aside today in the rate of interest is 5%? 47

Perpetuities & Annuities Example - continued If the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today? 49

Annuities Annuity: a sequence of equal cash flows, occurring at the end of each period. This is known as an ordinary annuity. 1 2 3 4 PV FV

Examples of Ordinary Annuities: If you buy a bond, you will receive equal semi-annual coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will pay a stream of equal payments.

Annuity-due A sequence of periodic cash flows occurring at the beginning of each period. 1 2 3 4 PV FV

Examples of Annuities-due Monthly Rent payments: due at the beginning of each month. Car lease payments. Cable TV and most internet service bills.

Perpetuities & Annuities PV of Ordinary Annuity Formula C = cash payment r = interest rate t = Number of years cash payment is received 50

Perpetuities & Annuities PV Annuity Factor (PVAF) - The present value of $1 a year for each of t years. 51

Perpetuities & Annuities Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments Mortgage payment Annual income from an investment payout Future Value of annual payments 54

Perpetuities & Annuities PV (and FV) of Annuity-dues = PV (or FV) of ordinary annuity x (1 + r) or BGN mode on financial calculator. C = cash payment r = interest rate t = Number of years cash payment is received 50

Example: Invest Early in an IRA How much would you have at age 65 if you deposit $2,500 at the end of each year in an account paying 9% annually starting at: (A) age 41? (B) age 22?

Why an IRA? Imagine in the last example, you didn’t take advantage of the tax-sheltered environment of an IRA. Your annual investment return would be taxed! With a 28% tax rate, our annual after-tax return would fall from 9% to 6.48% (=9%(1-.28)). At age 65: I would have $135,519 vs. $191,975. You would have $535,392 vs. $1,102,114: 52% less!! The IRS killed Kenny,…!

Example: Enjoying your Retirement You go ahead and make the contributions starting at age 22 in the last example, giving you $1,102,114 at age 65. You expect to live to age 85. So, you want to make 20 annual withdrawals from your IRA paying 9% at the beginning of each year starting at age 65. How large can this annual withdrawal be?

More annuity fun, enjoying your release from baseball Bob B. is released from the last year of his guaranteed contract from a New York baseball team. He is due $5.9 million from the last year of this contract. Bob and the team agree to defer the $5.9 million at 8% interest for 15 years. At this time (15 years from today), the team will begin the first of 15 equal annual payments at 8% interest. The press is reporting the payments will total $30 million. Are they correct?

Non-Annual Interest Compounding When interest is compounded more frequently than once a year. Important non-annual compounding terms and things to know: Quoted Annual Rate, or Annual Percentage Rate (APR): Stated nominal annual rate before compounding. Effective Annual Rate (EAR): the actual (effective) annual interest rate earned or paid. Periodic Interest Rate: the interest rate paid or charged each interest compounding period = quoted rate/m, where m = number of compounding periods per year.

Effective Interest Rates example Given a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What is the Annual Percentage Rate (APR)? 28

FV and PV with non-annual interest compounding n = number of years m = number of times interest is paid per year APR = nominal annual rate (APR) APR/m = periodic rate Single CF FVnm = PV(1+ARR/m)nm PV = FVnm/(1+APR/m)nm

Non-annual annuities Ordinary: PV = C(PVAFAPR/m,nm) FVnm = C(PVAFAPR/m,nm)(1+APR/m)nm Annuity-Due: PV = C(PVAFAPR/m,nm)(1+APR/m) FVnm = C(PVAFAPR/m,nm)(1+APR/m)nm+1

Example: Low Rate or Rebate? The Frontier family want to buy a sport ut (SUV). They decide on a 4-wheel drive Jeep Grand Cherokee. The purchase price with tax of the vehicle is $32,500. The Frontiers have $4,000 as a down payment. Jeep offers the choice of two incentives on the 4-door Grand Cherokee. 0% APR Financing for 60 months, or $3,000 rebate which would be applied toward the purchase price. If the Frontiers elect to take the rebate, they can get 4.49% APR financing for 60 months. Question: Which incentive would give the Frontiers the lowest monthly payment?

Example: The $200 national ISP signup credit: good deal for whom? A national ISP all provide $200 for new customers to use at a particular electronics store chain if they sign-up for a 2-year internet service contract at $21.95/month. What interest rate (APR) are you paying on this “free money” if you wanted internet service and could get it for free? (200 PV, -21.95 PMT, 24 N 0 FV, CPT I/Y = 9.8%/month x 12= 117.8% APR!!) What interest rate (APR) are you paying on this “free money” if you wanted internet service and could get it for $9.95/month?(-12 PMT CPT I/Y = 3.15%/mo x 12 = 37.8%! Thanks, but no thanks!

Inflation Inflation - Rate at which prices as a whole are increasing. Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases. 57

Inflation approximation formula 59

Inflation Example If the interest rate on one year govt. bonds is 5.0% and the inflation rate is 2.2%, what is the real interest rate? Savings Bond 62

Example: Real retirement income Going back to your retirement in 43 years, you expect 3% inflation along with your 9% nominal investment rate annually and want to withdraw $32,000 in real terms at the beginning of each year for 20 years once you retire. How will this change your retirement saving plans?